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Chapter 1Introduction
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 1
What is a Derivative?
A derivative is an instrument whose value depends on, or is derived from, the value of another asset.
Examples: futures, forwards, swaps, options, exotics…
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 2
Why Derivatives Are ImportantDerivatives play a key role in transferring risks in the economy
The underlying assets include stocks, currencies, interest rates, commodities, debt instruments, electricity, insurance payouts, the weather, etc
Many financial transactions have embedded derivatives
The real options approach to assessing capital investment decisions has become widely accepted
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 3
How Derivatives Are Traded
On exchanges such as the Chicago Board Options Exchange
In the over-the-counter (OTC) market where traders working for banks, fund managers and corporate treasurers contact each other directly
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 4
Size of OTC and Exchange-Traded Markets(Figure 1.1, Page 3)
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 5
Source: Bank for International Settlements. Chart shows total principal amounts for OTC market and value of underlying assets for exchange market
The Lehman Bankruptcy (Business
Snapshot 1.10)
Lehman’s filed for bankruptcy on September 15, 2008. This was the biggest bankruptcy in US history
Lehman was an active participant in the OTC derivatives markets and got into financial difficulties because it took high risks and found it was unable to roll over its short term funding
It had hundreds of thousands of transactions outstanding with about 8,000 counterparties
Unwinding these transactions has been challenging for both the Lehman liquidators and their counterparties
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 6
How Derivatives are UsedTo hedge risks
To speculate (take a view on the future direction of the market)
To lock in an arbitrage profit
To change the nature of a liability
To change the nature of an investment without incurring the costs of selling one portfolio and buying another
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 7
Foreign Exchange Quotes for GBP, May 24, 2010 (See page 5)
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 8
Bid Offer
Spot 1.4407 1.4411
1-month forward 1.4408 1.4413
3-month forward 1.4410 1.4415
6-month forward 1.4416 1.4422
Forward Price
The forward price for a contract is the delivery price that would be applicable to the contract if negotiated today (i.e., it is the delivery price that would make the contract worth exactly zero)
The forward price may be different for contracts of different maturities (as shown by the table)
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 9
TerminologyThe party that has agreed to buy has what is termed a long position
The party that has agreed to sell has what is termed a short position
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 10
Example (page 5)
On May 24, 2010 the treasurer of a corporation enters into a long forward contract to buy £1 million in six months at an exchange rate of 1.4422
This obligates the corporation to pay $1,442,200 for £1 million on November 24, 2010
What are the possible outcomes?
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 11
Profit from a Long Forward Position (K= delivery price=forward price at time contract is entered into)
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 12
Profit
Price of Underlying at Maturity, STK
Profit from a Short Forward Position (K= delivery price=forward price at time contract is entered into)
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 13
Profit
Price of Underlying at Maturity, ST
K
Futures Contracts (page 7)
Agreement to buy or sell an asset for a certain price at a certain time
Similar to forward contract
Whereas a forward contract is traded OTC, a futures contract is traded on an exchange
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 14
Exchanges Trading Futures
CME Group (formerly Chicago Mercantile Exchange and Chicago Board of Trade)
NYSE Euronext
BM&F (Sao Paulo, Brazil)
TIFFE (Tokyo)
and many more (see list at end of book)
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 15
Examples of Futures ContractsAgreement to:
Buy 100 oz. of gold @ US$1400/oz. in December
Sell £62,500 @ 1.4500 US$/£ in March
Sell 1,000 bbl. of oil @ US$90/bbl. in April
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 16
1. Gold: An Arbitrage Opportunity?
Suppose that:The spot price of gold is US$1,400The 1-year forward price of gold is US$1,500The 1-year US$ interest rate is 5% per
annum
Is there an arbitrage opportunity?
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 17
2. Gold: Another Arbitrage Opportunity?
Suppose that:- The spot price of gold is US$1,400- The 1-year forward price of gold is
US$1,400- The 1-year US$ interest rate is 5% per
annum
Is there an arbitrage opportunity?
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 18
The Forward Price of Gold (ignores the gold lease rate)
If the spot price of gold is S and the forward price for a contract deliverable in T years is F, then
F = S (1+r )T
where r is the 1-year (domestic currency) risk-free rate of interest.In our examples, S = 1400, T = 1, and r =0.05 so that
F = 1400(1+0.05) = 1470
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 19
1. Oil: An Arbitrage Opportunity?Suppose that:
- The spot price of oil is US$95- The quoted 1-year futures price of oil is
US$125- The 1-year US$ interest rate is 5% per
annum- The storage costs of oil are 2% per
annum
Is there an arbitrage opportunity?
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 20
2. Oil: Another Arbitrage Opportunity?
Suppose that:- The spot price of oil is US$95- The quoted 1-year futures price of oil is
US$80- The 1-year US$ interest rate is 5% per
annum- The storage costs of oil are 2% per
annum
Is there an arbitrage opportunity?
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 21
Types of Traders
Hedgers
Speculators
Arbitrageurs
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 22
Hedging Examples (pages 10-12)
A US company will pay £10 million for imports from Britain in 3 months and decides to hedge using a long position in a forward contractAn investor owns 1,000 Microsoft shares currently worth $28 per share. A two-month put with a strike price of $27.50 costs $1. The investor decides to hedge by buying 10 contracts
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 23
Value of Microsoft Shares with and without Hedging (Fig 1.4, page 12)
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 24
20 22 24 26 28 30 32 34 36 3820,000
25,000
30,000
35,000
40,000
No Hedging
Hedging
Stock Price ($)
Value of Holding ($)
Speculation Example
An investor with $2,000 to invest feels that a stock price will increase over the next 2 months. The current stock price is $20 and the price of a 2-month call option with a strike of 22.50 is $1
What are the alternative strategies?
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 25
Arbitrage ExampleA stock price is quoted as £100 in London and $140 in New York
The current exchange rate is 1.4300
What is the arbitrage opportunity?
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 26
Dangers
Traders can switch from being hedgers to speculators or from being arbitrageurs to speculators
It is important to set up controls to ensure that trades are using derivatives in for their intended purpose
Soc Gen (see Business Snapshot 1.3 on page 17) is an example of what can go wrong
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 27
Hedge Funds (see Business Snapshot 1.2, page 11) Hedge funds are not subject to the same rules as mutual funds and cannot offer their securities publicly. Mutual funds must
disclose investment policies, makes shares redeemable at any time,limit use of leveragetake no short positions.
Hedge funds are not subject to these constraints.Hedge funds use complex trading strategies, are big users of derivatives for hedging, speculation and arbitrage
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 28
Types of Hedge Funds
Long/Short Equities
Convertible Arbitrage
Distressed Securities
Emerging Markets
Global macro
Merger Arbitrage
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012 29